# Automatic wealth The 6 steps to financial independence - Masreson M.

ISBN 0-471-71027

**Download**(direct link)

**:**

**80**> 81 82 83 84 85 86 .. 110 >> Next

My actual net rents over the four years were $7,934 minus $1,500 (one month of rent in year one) minus $1,654 (one month of rent in year three). So my net rents for the four years were $4,780 (an average of about $100 a month).

Step 5: Get Richer While You Sleep 201

If we add this to my profits from appreciation and amortization, we get my total profits:

Total net rents of $4,780

Plus profits from appreciation and amortization of $159,200 Equals total profits of $163,980

So in four years’ time, I made about $164,000 on a property I bought for $182,000. But that doesn’t mean I almost doubled my money. I made much more than that because of leverage.

I didn’t pull $182,000 out of my pocket to buy the house. My initial investment was the down payment, renovation costs, and closing costs on the purchase. Those, as we’ve seen, totaled $65,400. So my profit, as a percentage of my original investment, was actually 251 percent.

Total profits of $163,980

Divided by total initial investment of $65,400

Equals leveraged profits of 251%

Same House, Very Different Results

I made a significant profit on this house. Yet the woman who bought it from me wasn’t nearly as fortunate. She is also an investor. And she had made great money on various properties here in town as the market rocketed up 15 percent to 20 percent in recent years. She bought my house at $390,000, moved in, put $20,000 into it, and then put it on the market for $475,000.

But there were no buyers at that price. Or at $450,000, or

$425,000, or $400,000. After a year on the market, she unloaded it for

$350,000—representing roughly a $101,000 loss.

Here’s how her deal looked. First, we calculate the appreciation (or, in this case, the depreciation):

Sale price of $390,000

Less purchase price of $350,000

Equals depreciation of $40,000

Next, we look at her gross equity when she finally sold the house:

202 AUTOMATIC WEALTH

Sales price of $350,000

Less loan balance due at sale of $308,600*

Equals gross equity of $41,400

Then, we take out sales commission and closing costs to get her net equity:

Gross equity of $41,400

Less 6% sales commission of $23,400

Less seller’s closing costs of $2,000

Equals net equity $16,000

Now, let’s figure her total, out-of-pocket expenses:

Down payment of $78,000

Plus closing costs on purchase of $6,000

Plus renovations of $20,000

Equals total initial investment of $104,000

Add to that what she lost from the depreciation:

Net equity of $16,000

Less total initial investment of $104,000

Loss after depreciation and amortization of -$88,000

And now her carrying costs, which were more than mine since she paid more than twice what I did for the house and because taxes and insurance go up with higher sales prices:

Principal and interest of $1,875

Plus taxes of $500

Plus insurance of $150

Plus average monthly maintenance of $150

Equals total monthly carrying costs of $2,675

*Buyer borrowed 80 percent of $390,000, or $312,000. Interest rates had fallen to 6.5 percent by this time. After one year at 6.5 percent, her balance due on the loan, or payoff amount, was $308,600.

Step 5: Get Richer While You Sleep 203

Since we now know what she has to spend to keep the property and since we know what she receives in rent, we can figure her net rents. In this case, the net rents are negative:

Rental income of $1,825

Less monthly carrying costs of $2,675

Equals negative net rent of $850

Yearly negative net rent -$10,200

In addition to this, she had one month of vacancy in the year she

owned the property. So her net rents for the year were -$12,025 ($10,200 - $1,825).

Total negative net rents of -$12,025

Plus loss after depreciation and amortization of -$88,000

Equals total loss of -$100,025

So why did this woman lose so much money when I made so much on the same house?

Autopsy of a Bad Deal

The number one mistake this buyer made was that she didn’t have a margin of safety going into the deal. Her purchase price wasn’t anchored to reality by rental values. By contrast, when I first bought the house, at $182,000, it had a $1,500 monthly rental value. Since interest rates were 7.5 percent at the time, my rental income covered my loan payments, taxes, insurance, and maintenance and still gave me a 5 percent margin of safety.

That’s not a huge margin of safety but a fair one, given the strong appreciation potential of the neighborhood. What’s more, as rents rose, my margin of safety increased every year. By year four, I was receiving rent of around $1,736 a month and netting $253 after all expenses.

That meant rents could fall as much as 15 percent at that point without my experiencing negative cash flow. And if the rise in housing prices suddenly dipped, or even stopped, I could afford to bide my time.

204 AUTOMATIC WEALTH

By contrast, by the time this woman bought the house from me, the rental value had risen to only about $1,825. Even though interest rates had come down to 6.5 percent at that point, the rent still wasn’t nearly enough to cover her loan payments—let alone her other costs.

**80**> 81 82 83 84 85 86 .. 110 >> Next